Value abounds amid American gloom

It is rare to see the market totally lack consensus, as it did in the aftermath of Standard & Poor’s decision to downgrade US downgrade to AA+ from AAA in August. While the severity of the structural problems in global markets is undisputed, corporate America is thriving and stockmarkets are enjoying a number of positive tailwinds, confusing the picture.

US stocks fell 10 per cent in the week following the downgrade, leaving the S&P 500 trading at around 12 earnings, a rich hunting ground for active stock pickers, who pointed out that these were the same stocks that in 2000 sold for more than 30 times earnings.

RATES REMAIN LOW

Plummeting prices also meant the dividend yield on many stocks was similar to government bond yields, such as the 2.5 per cent paid on benchmark 10-year Treasuries. Comparisons will continue to look attractive as interest rates are now expected to stay at rock-bottom for some time.

Moreover, corporate profits reached record highs in the second quarter, historically often a first step toward a durable economic recovery. Companies flush with cash have been boosting their dividends and many are now looking to grow their businesses by merger and acquisition. Bear markets rarely take root when corporate earnings are healthy and interest rates low. There are also other ad hoc tailwinds, such as the Japanese disaster, which slowed economic growth in the second quarter, but will create a rebuilding bonanza in the rest of 2011.

However, plenty of disappointing data points to slower US growth while the deleveraging process runs its course. Although the US economy has expanded for eight consecutive quarters, growth in the past two quarters has been feeble. Confidence in the US manufacturing sector has also dipped below expectations, according to the Institute of Sales Management survey of manufacturing confidence, which is generally a good predictor of markets. While employment data has been broadly in line with expectations, the 117,000 new jobs created in June marked progress of only meagre proportion.

“Our view, at least for the time being, is that we are facing an economic slowdown, but not a recession, and the economic environment will proceed at an extremely low rate of growth,” says Habib Nasrallah, senior product specialist for core equity funds at Pictet.

“The US corporate sector is in its best shape, having already downsized its labour force, and inventory levels are lean. Moreover the contribution of the housing market to GDP has fallen from 7 per cent to 3 per cent, so the continuous house price decline won't have the scale of impact it had three years ago. We don’t have the ingredients for another recession.”

For the brave, there are plenty of opportunities in equity markets. “The S&P 500 index is trading at just under 12 times – historically that level has been very attractive,” says Mark Stoeckle, CIO, US and global sector equities at BNP Paribas Investment Partners.

“A lot of air has been taken out of the markets so there are some pretty attractive valuations. Over the last four years, US companies have shown an amazing ability to generate top-line growth and EPS (earnings per share) growth in very difficult and uncertain times. The second quarter earnings season has been good with each sector exceeding EPS estimates,” he explains.

“Companies have been able to deliver this growth because they are lean, and the consumer has been amazingly resilient throughout this whole process,” adds Mr Stoeckle.

“I’d say there is a bifurcation between the low end which has been limping along and the mid and particularly high end which have been doing remarkably well,” he explains. “And the fall in energy prices in the last few months have been almost a direct rebate to the low end consumer, and a tailwind for all consumers.”

Most active managers in this space are focusing on large cap quality stocks, preferably dividend-payers, with strong balance sheets and dominant positions in their markets, whom they believe will still be able to increase their top-line growth in a morose environment. Megacap stocks have underperformed for some time, and as investors look for safety, these types of stocks are attractive.

“While we’re aware that public sector stimulus is fading fast, we do see the economy as having a mid-cycle correction rather than a reversal,” says Jonathan Price, client portfolio manager for US equity at JP Morgan Asset Management. “Corporate America is still in good shape.”

He thinks there are strong opportunities in the media and tech sectors. “In traditional media, the risk from the internet challenge is overdone and the ability to grow advertising revenue is underappreciated,” says Mr Price. “In tech, there is a move to greater mobility and to cloud computing, and US companies are well placed to play that secular shift. There has been some component supply side disruption from the Japanese disaster but long term fundamentals are strong.”

Several fund managers cite Cisco and Apple to demonstrate that even the largest tech stocks are now cheap.

DEFENSIVE STOCKS

Adrian Brass has shifted the Fidelity fund towards more defensive sectors and later cycle cyclicals, adding healthcare, software and aerospace. “The reversal in the risk tolerance of the market has led it to be less patient in waiting for these later cycle areas to improve and therefore even though they have substantial relative upside, they have performed poorly in the sell-off,” he says.

In future, drivers of growth may be different, however. “Historically, US market growth has come from the US consumer, as well as technology and healthcare,” says Greg McIntire, portfolio manager of the SEI Large Cap Team.

“This recipe has worked for over a decade, but is now challenged for cyclical and secular reasons. The consumer continues to deleverage in the wake of our housing crisis and is also secularly challenged as we have to deal with our national entitlements going forward,” he explains.

“The ageing population also saw tremendous growth in the healthcare sector in the past several years, but national debate about the cost of healthcare makes this a harder avenue of growth going forward. Technology has long been staple for growth, but it, along with many US corporate revenues, have become increasingly non-US in origin in recent years.”

Getting the timing right is difficult. Few believe the US is really less creditworthy than the 16 countries that maintain triple A ratings, but that will not prevent three months of uncertainty as Congress works out where the remainder of the $1,500bn (E1,040bn) in spending cuts are coming from. If the dollar loses its status as a reserve currency, that would precipitate a strong rise in long US rates and further damage stock markets, but the risk of this is low because there is no real alternative for international investors.

“Another issue is cost control in a potentially inflationary environment,” says John Carey, US equity portfolio manager at Pioneer Investments. “Food prices rose last year and cotton spiked, and we have seen some food and clothing companies able to pass on some of these costs, but it is still a challenge.

“The demographic shift is also an important consideration but people only focus on it sporadically,” he adds. “As the baby-boomers move to the ranks of the retired in the next few years, there is the potential that this could lead to a change in investor behaviour. We have had 10 volatile years where equities have not performed well, and this group could be cautious which could affect demand for certain types of stocks,” says Mr Carey.

VIEW FROM MORNINGSTAR

Winners continue to emerge

Despite the uncertainty surrounding US growth and the recent downgrade of US sovereign debt, American stock markets can still prove appealing for clever investors able to identify potential winners in the region.

While over the one year period to 4th August the S&P 500 index rose less than 1 per cent in euro terms, some funds managed substantial gains. The Morgan Stanley US Advantage fund experienced a return of more than 9 per cent. Certainly, the fund holds some foreign stocks such as the European Edenred, but the main contributing factor is probably its sector allocation. With as low as 4.34 per cent of its assets invested in energy, the fund is three times less exposed to the sector compared to the average fund in the category. Instead, it has made strong bets on the consumer services sector.

Not all strategies were winners – JPM US Select 130/30 returned only 0.39 per cent over one year. Yet one should note that a fund may show varying returns for different share classes based on currency exposure. Specifically, euro hedged classes delivered much better as the euro rose against the dollar.

European investors investing in foreign stock markets face one common value trap – fees. The US large-cap blend equity category is no exception: with a total expense ratio (TER) of 2.85 per cent, a fund like Mediolanum Ch North American Equity has found it difficult to outperform. Similarly affected is the Eurizon EasyFund Equity North America fund with a TER of 2.07 per cent, which Morningstar has rated Inferior due to its small tracking error and and its diffuse portfolio limiting its ability to generate enough alpha to offset its high fees.

Frederic Lorenzini, director of research, Morningstar France

Slim pickings for active managers

Four of the 10 largest US equity funds are exchange traded funds, as might be expected in this mammoth and relatively efficient market. Although the PWM figures are restricted to active managers, Vanguard has done a lot of

research on the relative merits of passive and active investment and whatever way the numbers are crunched, very few active managers outperform the index.

For the S&P 500 index over the last 15 years, 84 per cent of active managers underperformed the benchmark, 70 per cent underperformed it over a 10 year period, and 72 per cent underperformed it over one year. Passive funds from UBS, iShares and db x trackers are among the best performers. Even in the small cap arena, where information is arguably at a premium, 74 per cent of active managers failed to outperform the S&P SmallCap 600 over both 15 and 10 years.

“At any time in the last 10 or 15 years, you would often hear people say that this is a stock picker’s market, but it has not been so,” says Chris Philips, senior analyst at Vanguard Investment Strategy Group. “We need to combat the notion that indexing only works in efficient markets. It works in all markets owing to the costs of implementation, manager fees and just the general difficulty of picking stocks.”

Very active, short-term investors with a horizon of days to weeks might gain exposure to market moves, using cost-effective instruments such as ETFs or derivatives such as options, futures or forwards, says Michael Rist, head of investment advisory services at Bank Julius Baer. “Given the substantial return dispersion between single instruments and particular market segments, the longer the time horizon, the more probable value is to be derived from actively managed products. Also, certain active products are preferred to implement very specific ideas.

“For actively managed equity funds, empirical evidence suggests that selectivity is key in determining investment success,” he says. “However, it should be underscored that the winners and losers among active managers change according to the measurement period, as their respective strategies’ performance depends on the prevailing environment.”

Since April, Bank Julius Baer has been recommending a reduction in cyclical exposure and increased focus on defensive segments, such as healthcare and telecoms, value and large cap styles, and high-dividend-yield stocks.

Coutts highlights the value of secure dividend yields in a low-rate environment, strong balance sheets and business models focused on exporting to Asia and emerging markets. “We expect the deleveraging process to keep interest rates lower for longer, making equities with higher dividend yields look attractive relative to government bonds and cash deposits,” says James Butterfill, equity strategist at Coutts.

Coutts also likes companies that combine a high level of spending on research and development (R&D) with above-average profit margins. “High R&D spend indicates strong intellectual capital, and companies where this is coupled with a high return on invested capital typically outperform,” Mr Butterfill says.